Business Valuations

This could be something closer to a book than a thumbnail entry, but I give it my best shot at condensation. The key case in Michigan is Kowalesky v. Kowalesky, 148 Mich App 151 (1986). In fact, I havenít found any other published case that is very useful, at least as a matter of outlining value issues. Kowalesky concerns valuation of a dental practice. The owner of the business suggested that the practice should be valued by use of a "going out of business" or "distress" sale. His spouse suggested that Revenue Ruling 59-60 should be used, a method for valuing closely held corporations for estate and gift tax purposes.

The Kowalesky court, wisely, commences with the notion that "no single method should uniformly be applied in valuing a professional corporation." Rather, the court suggests that trial courts should have discretion, subject to the "clearly erroneous" standard of appellate review. 148 Mich App at 155-156. However, the court goes on to outline several important principles. These are---

The value of a business is its assets less the liabilities. The assets of a business include accounts receivable. To not value such an asset is error. The assets of a business also include the intangible assets, most notably the "good will" of the entity. To not value the "good will" would be error. Use of the "distress sale" value suggested by the dentist would be error, unless there is evidence that the business is being sold in such a fashion. If a business is continuing, the valuation should focus upon the value to the operator as a "going concern". The "value of an asset is not directly affected by the fact that a party is under a support obligation.

These statements are found at 148 Mich App at 156-158. Kowalesky has not spawned much litigation, though it is certain that all subsequent cases have attempted to follow its principles. See, however, Lefko, Holderís Interest Concept, Defined, Discussed and Explored, 71 MBJ 293 (1992) and Cunningham, Equitable Distribution and Professional Practices; Case Specific Approaches to Evaluation, 73 MBJ 666 (1994) for two excellent articles picking through the bones of Kowalesky.

The cases that come after Kowalesky have made two things clear. First, the appellate courts are unlikely to fuss around or second-guess the expert valuations at the trial level. If the decision of the court falls within the expert testimonies at trial, the appellate courts donít want to seem to get in the way, so long as the principles listed above have not been trampled. See e. g. Pelton v. Pelton, 167 Mich App 22, 25 (1988); Perrin v. Perrin, 169 Mich App 18, 22 (1988); Rickel v. Rickel, 177 Mich App 647, 649 (1989). Golden v. Golden, No 218106 (unpublished, March 20, 2001).

A related point is axiomatic---get an expert. And it will also be wise if the expert has no association to the business. The business accountant, for example, is a poor choice---even if the guy is the second coming of John Maynard Keynes with a CPA and a profound history of valuing businesses. This expert will always look like a homer and will have some strikes against him as he enters the fray. In a 12pt business---where money may be tight---I would always suggest the parties consider the hiring of a neutral appraiser and evenly share the cost. In a 18pt business there is a place for an expert representing each side, but it makes sense for the experts to be allowed to consult with one another. The differences in the expertsí views, if any, can often be pared to a place where negotiation is feasible.

The brilliant part about the Kowalesky opinion is that it took the valuation issue "away" from anything other than the grossest appellate review, and placed it back into the hands of the experts---accountants as measured by those with the more profound history of dealing with the problem, trial judges and referees. Honest. No irony intended. And I would suggest the same thing should happen in all other domestic areas and the world would be a better place for everyone---most especially parents and children---and that includes appellate judges, whose skills and expertise can be better used than being a part of the facilitation of impossible fees in family litigations. The only ones who might suffer---well, let me desist.

In any event, Kowalesky has spawned discussion in exactly the right place, expert debate and publication about the valuation of various kinds of businesses and the externalities of business valuation issues. [Compare this, for example, to the foreclosure of debate caused by the disgraceful and ill reasoned Burba v. Burba in the child support arena.]


The recent, noteworthy matter of accountant debate concerns the interplay of alimony on the business evaluation. Take a 12pt business run as a dba that is valued by the ordinary process of assets versus debts. In adding the good will to the equation an accountant would ordinarily look at the excess of the proprietorís actual compensation over his fair labor market value or "reasonable compensation" and then capitalize the difference---usually by some factor between 2 and 5.

Assume, for example, the proprietor draws an income of $ 100,000 per year and the expert discerns his "reasonable allowance for compensation" at $ 60,000. The accountant would then capitalize the $ 40,000 difference, adjust for taxes, and add a "good will" number to the asset minus debts total. The question then becomes, what number is used for any alimony analysis? Historically, accountants argued for using an income of $ 60,000, since the remainder had already been divided in the "good will" calculation. This notion was attacked by Grace Blumberg in her article "Identifying and Valuing Goodwill at Divorce", 56 Law and Contemporary Problems, No 2. (Spring 1993).

Prominent Michigan accountants picked up on the Blumberg argument, noting the frailty of the historical calculation. See Rogow, The Calculation of Earnings for Support in Conjunction with a Business Valuation, 25 MFLJ 12 (January 1998) and Cunningham, Tax Trends and Developments, 27 MFLJ 6 (January 1999).

There are a number of possible solutions to the problems outlined in these articles but the simplest one is an adjustment in the ownerís income over the period of capitalization. In other words, in the example above, the ownerís income would be adjusted by $ 40,000 per year for the period chosen to capitalize. If the good will was valued by using a cap rate of "3", the income adjustment would accrue over three years----and not thereafter. See the Cunningham article for other remedies. The point here is twofold. First, that thought is this arena continues to evolve. Second, in looking to a business/alimony valuation the practicing attorney should be aware of the "basic" accounting problems when looking at an expertís work. The "obvious" and "simple" notion of the "double count" is anything but obvious and should be confronted by the expert.

Joe Cunninghamís most recent article further muddies the "double count" waters where he appears to be moving to the Blumberg theory, at least in some set of cases. See Tax Trends and Developments, 30 MFLJ No 6 p. 7-10 (August/September 2001). Joe concludes that an automatic application of the "sheltering" of the income upon which "good will" is predicated "can result in inequitable results in some cases" and he now suggests a "case specific" application of principles. Joe raises perplexing issues in the article but I think some/all of his arguments may be flawed. The question is, to be sure, an evolving area.

The methodology outlined above is a typical process in a 12pt business or a professional practice. It is not the only method of valuation, however, and in larger, non-professional entities a more common method may be a "cash flow" method as based upon discounted future earnings. This can be a complicated analysis, with assumptions being made about the growth of the company, discount rates over a long period of time, assets that might exist in excess of operational need and a discount for lack of marketability in the instance of a minority holding. For those lurking around the Washtenaw County Courthouse an example of this sort of analysis can be seen in Kushigian v. Kushigian, Case No. 91-43907-DM. The Arbitration Opinion in that case also contains a brilliant attack on the notion of "separate property" in Michigan. Ok, you can excise the word "brilliant".

As to the impact of Buy-Sell agreements on valuing a business, see Aviv and Wolock, "The Legal Significance of Pricing Formulae in Buy-Sell Agreements In The Equitable Division Of Property-An Open Question In Michigan" 31 Michigan Family Law Journal No 3 at page 13 (March, 2002)